Scott Sumner posted some quotes from an interview with Michael Woodford by David Andalfatto that dovetails with some basic Market Monetarist ideas, that large scale asset purchases by the central bank may not have the desired effect of lowering long-term interest rates, and that one should never reason from a price change. It a great post that ends with a rebuttal of the Cantillon effect.
In the post Scott suggests reading the entire interview for an in-depth explanation of the view, which I did. After doing so, I am quite surprised by the fact that there wasn’t more criticism of Woodford because the information provided is framed in such a way as to be ambiguous in regard to whether asset purchases are a desirable thing under the current circumstances. And I’m stuck here because I think even the description of “ambiguous” is rather a charitable way of describing Woodford’s argument about an idea to which he appears to be opposed.
There’s nothing wrong with being opposed to LSAPS. If he is opposed, it would be nice if he didn’t attempt to disguise it in ambiguity. He should say something like, “I think it’s a bad idea because…” and provide relevant information about why so his audience can either be persuaded or unconvinced. It’s not hard to do.
At any rate, after reading the interview I am convinced that his argument isn’t persuasive. My reservations about the argument do not concern what is there, but what isn’t that leaves some doubt. His basic argument is that LSAPS are, by their nature, a public institution taking on risk that others may not want to take on; and in doing so, the central bank is forcing risk on the public that it may not be desirable. His solution to LSAPs is that the central bank should not let the government off the hook in failure to use fiscal policy to revive the economy. This is my interpretation of it anyway. He admits that LSAPS probably don’t cause market distortions, a good point. He also admits that they probably don’t reduce long term interest rates; another good point.
But he takes the long way around to describe how, when the central bank takes on risk, it is forcing the public to take on risk that it may not want, leaving it for taxpayers (which I am assuming to be a proxy for inflation risk) – which I find to be very narrowly tailored to what seems to be a preferred result as to be misleading. It’s misleading in two ways:
1) The graph of Fed asset holdings that is posted with the interview clearly illustrates points I have raised previously regarding sterilization of extended bank lending throughout most of 2008 while the demand for liquidity was rising. What responsible central bank reduces its asset holdings in the throes of recession, and why is that particular question about reducing asset holdings, reducing risk while the rest of the public also reduces risk not a worrisome thing? And so if we’re in a situation where unemployment is spiking, markets are crashing, and there is a magnitude of financial chaos not seen since 1931, which priorities are to weighed against any particular Fed action, in this case LSAPs? It all comes down to a choice of bearing the opportunity cost of liquidation and the real cost to taxpayers of taking care of the people who are severely harmed by it or putting risk on the balance sheet of the Fed.
2) The use of the word “taxpayers” is a problem simply because when the average member of the public hears it, they think of themselves and everyone who has to file a US tax return. It is misleading in two ways, by neglecting to explain that in this case “taxpayer” means anyone holding USD denominated assets and that a small fraction of those are held domestically. And there is perhaps a third way, by neglecting to mention that it would apply to the extent that liquidity provided by the Fed to meet liquidity demand as a result would lead to inflation – which is far from certain. It depends on the circumstance.
These are my two main objections to the entire framing of the argument by Woodford in the interview. But there is one more that is not related to economics. It’s the idea that the Fed should place the onus of correcting its wrongs on fiscal policy; i.e. Congress. So the Fed has this 2% inflation target, which in the last few years has appeared to be considerably lower than that. This target is somewhat a derivative of the mandates that were amended to the Federal Reserve Act in the late 1970’s. And these things, these mandates, do not provide the Fed with an option of deciding not to cooperate with the political system, which I think the “shall” that prefaces the mandates makes pretty clear.
It’s perfectly acceptable to argue that the mandates, or the law governing the operation of the Federal Reserve should be changed. And there are reasonable arguments to be made on both sides of that debate. In fact, I agree the law should be changed. It should provide accountability on the part of monetary policymakers that currently is lacking, at the very least (although I think the use of the SEC is a reasonable substitute until that happens). I also believe that the mandates, as stated, are too susceptible to narrow construction. But the law is pretty unambiguous about which agency of government is considered the tail and which part of government does the wagging. The idea that appointed Fed bureaucrats or those elected by bankers can defer all of their responsibility to politicians is rather absurd in a democratic society – and any member of the Fed who doesn’t feel the need to show proper respect toward our institutions and our laws should not be there.